- This question asks you to describe the macroeconomic effects of a monetary expansion. The experiment involves the Bank of Japan (BOJ) announcing a permanent one‐time increase in the Japanese money supply. Assume that the Japanese real national income is unchanged, that nominal interest rates are positive (and above 0%), and that Japanese prices are slow to adjust to changes in monetary policy.
a) Describe the likely short‐run effects of the permanent one‐time expansion in the money supply on the nominal interest rate in Japan and the value of the yen relative to the dollar.
b) Describe the likely long‐run effects of the permanent one‐time expansion in the money supply on the nominal interest rate, the real money supply, the price level, and the nominal value of the currency.
c) What is likely to happen to the expected real interest rate in the transition to the long‐run?
d) In reality, the BOJ has been expanding the Japanese money supply almost continuously for a number of years, yet the value of the yen has not always changed in the expected direction. What might explain why the model has not worked well for Japan?
e) How would your answers to parts (a) and (b) change if instead of Japan we were analyzing a country with a history of high inflation, (so that prices quickly adjust to changes in monetary policy)?
- In our discussion of short‐run exchange rate overshooting, we assumed that real income (or output) was given. Assume instead (more realistically) that an increase in the money supply raises real income in the short run.
a) How does this affect the extent to which the exchange rate overshoots when the money supply first increases?
b) Under what circumstances (if any) is it likely that the exchange rate undershoots when the money supply first increases?
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